What Banks Need To Know When Clients File For Bankruptcy September 13, 2012 Squire Sanders (US) LLP Bradley A. Cosman Jeffrey S. Renzi Bankruptcy & Restructuring Associate Litigation Senior Associate 555 S. Flower Street, 31 st Floor 1 E. Washington Street, Suite 2700 Phoenix, AZ 85004 Los Angeles, CA 90071
Outline • Automatic Stay under Bankruptcy Code § 362 • Financing the Bankruptcy - Cash Collateral and DIP Financing • Impacts of Collateral Valuation • Pre-Bankruptcy Remedies 2
Automatic Stay • One of the most important protections for debtors • Nationwide, possibly even worldwide, injunction barring almost all actions against the debtor and its property • Triggered automatically upon filing • Purpose – Provide debtor with a breathing spell from pressure and demands of creditors – Prevent “race to the courthouse” - depletion of the bankruptcy estate in favor of one creditor at expense of others • Violators subject to sanctions 3
Automatic Stay • Enjoins, among other things: – Exercise of remedies with respect to collateral; – Enforcement of prepetition judgments; – Litigation; – Informal collection efforts, such as calling the debtor or sending threatening demand letters; – Acts to create, perfect and enforce liens granted before the petition date; and – Application of Setoff (netting prepetition debt owing to the debtor against a claim asserted against the debtor arising from a different transaction) • But, consensual negotiations with debtor are permitted 4
Automatic Stay Limitations – Actions Against Non-Debtors Automatic Stay does NOT extend to non-debtor third parties ( e.g. guarantors, affiliates, co-debtors, officers and principals, co-defendants and partners) • But . . . Bankruptcy Court’s have extended stay to non-debtors when a claim against the non- debtor will have immediate adverse economic consequences for the bankruptcy estate • Known as a “§ 105 Injunction” • E.g. – Action against the non-debtor principal / guarantor of small company may be enjoined due to “identity of interests” 5
Automatic Stay Limitations – Letters of Credit • Stay does NOT prevent a beneficiary to draw down on a LOC issued on account of a debtor – Stay does not apply because LOC is not property of the estate • Once drawn down by the beneficiary, the lender issuing the LOC immediately has a secured claim against the debtor for reimbursement 6
Automatic Stay Exception – Postpetition perfection of prepetition security interest allowed in 2 situations: • Retroactive Perfection Permitted by Non- Bankruptcy Law – E.g. – Purchase Money Security Interest (PMSI) – But, must still perfect in the statutory grace period • Filing UCC Continuation Statement 7
Automatic Stay Relief from Stay • May be granted by the court on its own, or on request from a party-in-interest after notice and hearing • Courts may be reluctant to grant relief early in case, but lenders should still consider seeking relief as a means to: – Ensure provision of adequate protection – Force debtor to respond – Create a baseline to establish cause for subsequent stay relief • E.g. – failure to make adequate protection payments; lack of progress; diminution in value 8
Automatic Stay Grounds for Relief from Stay 1. “For Cause” - Including Lack of Adequate Protection a) From a secured lender’s perspective, this is the most important basis for relief b) Secured creditors are entitled to “adequate protection” to protect against diminution in value of their collateral during the bankruptcy case i. Diminution can be caused by variety of factors, including depreciation, physical loss, or damage ii. These types of losses are attributable to the Automatic stay c) But, an equity cushion in collateral may be deemed adequate protection (measured only as to specific creditor’s lien, not all liens) 9
Automatic Stay Grounds for Relief from Stay 2. No Equity in Collateral & Collateral Not Necessary to Reorganization a) The first requirement is satisfied if the total of all encumbrances exceeds value of the property. b) The second requirement requires the debtor prove that the property is subject to an effective reorganization with a “reasonable possibility of success within a reasonable time” c) As a practical matter, obtaining stay relief on these grounds is difficult early in case. 10
Automatic Stay Grounds for Relief from Stay 3. Single Asset Real Estate cases a) Single asset real estate (“SARE”) cases essentially involve business operations with a single real estate property or project other than residential real property. b) SARE cases are usually two-party disputes c) Lender will be granted stay relief unless one of the following occurs within the first 90 days of the case: i. The debtor files a plan that has a reasonable possibility of being confirmed in a reasonable time frame; or ii. The debtor commences monthly interest payments at the non-default contract rate 11
Automatic Stay Grounds for Relief from Stay 4. Bad Faith filing a) The Automatic Stay may be lifted if the bankruptcy court finds that the case was filed as part of a scheme of delay, hinder, and defraud creditors. b) SARE cases are usually two-party disputes c) Lender will be granted stay relief unless one of the following occurs within the first 90 days of the case: i. The debtor files a plan that has a reasonable possibility of being confirmed in a reasonable time frame; or ii. The debtor commences monthly interest payments at the non-default contract rate 12
Automatic Stay Waivers • Bankruptcy Code does not expressly prohibit prepetition anticipatory waivers of the automatic stay • Regardless, lender MUST file a motion for relief from stay to enforce the prepetition waiver • Prepetition waivers are considered on a case-by- case basis along with other factors such as sophistication of parties, timing, consideration, evidence of coercion, and other circumstances •Most prevalent in SARE cases 13
Financing the Chapter 11 DIP financing, or Cash Collateral, or Both The Debtor must have access cash to finance postpetition operations. If unencumbered cash and cash collateral are insufficient, then the debtor must obtain DIP financing Cash Collateral – Cash generated from the sale of prepetition inventories or collection of prepetition receivables DIP Financing – New money lending to the debtor, usually on a priming basis Cannot force a lender to provide DIP Financing under the Bankruptcy Code 14
Financing the Chapter 11 • Cash Collateral can only be used by the debtor with the creditor’s consent or if the court, after notice and a hearing, finds that the creditor is adequately protected and authorizes the use • What constitutes adequate protection? Three non-exclusive methods – Cash payment or periodic payments – Additional or replacement liens – “Indubitable equivalent” – (defined by case law, essentially something of equivalent value) 15
Financing the Chapter 11 • Bankruptcy Code provides incentives to encourage creditors to lend to debtors using DIP financing • Can be structured as asset-based revolvers advanced against a borrowing base, or as term loans 16
Financing the Chapter 11 • Four variations of DIP financing: – Unsecured financing with super priority claims • Lenders should avoid if possible – Financing secured by liens on previously unencumbered assets – Financing secured by junior liens on previously encumbered assets – Financing secured by senior or priming liens on previously encumbered assets • Only available as last resort • Require consent of prepetition lender or evidence of adequate protection 17
Financing the Chapter 11 • Reasons and Benefits for Providing DIP Financing – Large transaction fees – High interest rates – Low repayment risk / strong collateral position – Control – establishing milestone deadlines, require retention of CRO, etc. – Loan-to-Own (offensive) – strategic play contemplating conversion of deb into controlling equity position – Improved Priority/Increased Collateral/Validation of Liens and Releases (Defensive) 18
Collateral Valuation • General Rule: Oversecured creditors may receive postpetition interest payments, but undersecured and unsecured creditors generally do not – Oversecured creditors may also be entitled to attorneys’ fees, professional fees, and other similar fees if provided for by contract or statute – Some courts allow undersecured and unsecured creditors to add postpetition fees and costs to their unsecured claim if provided for by contract 19
Collateral Valuation • When is collateral valued? – Depends on the circumstances and purpose of the valuation, but is frequently the confirmation date’ • How is collateral valued? – Depends on the type of debtor and nature of collateral • Real estate - fair market value based on sales comps • Operating entity – discounted cash flow, sales multiple 20
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